Getting loans is easy these days, especially if you are salaried and have the right credit profile. And there are loans available for everything. You can easily get loans for travel, home renovation, wedding, medical treatment or anything under the sun. You can get these loans quickly too. A few platforms claim to provide loans in a few minutes.
In a way, it is good that you have easy access to credit. If you believe in instant gratification, these quick loans are a boon. However, discipline is extremely important. A worry is that these easy loans shouldn’t become a habit. It is not very difficult to lose credit discipline when you have easy loans available. Today, you take a loan to purchase a gadget. Tomorrow, you fund your vacation through a loan. If you can’t keep up, you will have to soon take a loan to pay off these loans. And that is a clear indication that you have borrowed too much.
Given what I do, I occasionally come across people who have a serious debt problem. They earn a lot of money. However, their EMIs take a big chunk of it. Their investments and financial planning suffer because of this. Given how life is, it is difficult to pinpoint where things started going wrong. Perhaps, it began with taking a small loan to purchase a gadget. A few other similar loans followed. EMIs were still manageable. A financial or a medical emergency in the family tilted the scale against them. They had to take a gold loan and a personal loan. Thereafter, it became difficult to get out of this cycle.
Typically, incremental loans come at a higher cost. You start with a personal loan from bank, then to a loan from fintech company and then to a Peer-to-Peer borrowing (lending) platform. If even that is not enough, you go to a local money lender. The cost of borrowing will keep going up, pushing you ever closer to a debt trap. Initial loans are cheap and easy to get. Thereafter, loans can become unavoidable and expensive.
What Should You Do?
There are two kinds of loans. The first type is discretionary and avoidable (gadget purchase, travel etc). With such loans, you need some credit discipline and you should be fine. The second type is a forced or an unavoidable loan (medical/financial emergency). This is more difficult to manage but you can reduce risk through proper financial planning.
Many a times, the rub of the luck will go against you. Medical emergencies or sudden financial emergencies can make loans unavoidable. If your debt problems started with such a loan, there is little you can do expect that you should have been better prepared. Adequate insurance coverage and emergency buffers can help.
DISCRETIONARY AND AVOIDABLE LOANS
Avoid living beyond your means (i.e., don’t spend more than you earn).
Avoid borrowing indiscriminately for gadget purchases, vacation / travel etc.
Your EMIs shouldn’t breach certain threshold (say 40-50%) of your in-hand income.
About loans for expenses that are discretionary, don’t make mistakes there. Don’t borrow indiscriminately. Don’t give into peer pressure or fall for instant gratification. You can’t live beyond your means for a long time. Reality will catch up eventually.
Be objective. Be rational.
You can avoid pain if you are pragmatic. If your existing loans are difficult to manage, shouldn’t you avoid another loan? What is the need to purchase an expensive phone on No-Cost EMIs? Why take another loan to fund an expensive vacation? You are better off using funds to repay the loans.
If you have assets such as gold or stocks or mutual funds, you must actively consider selling off those assets if you need money or to reduce your debt (rather than taking loans against such assets). I have discussed this aspect in detail in this post.
If you are young, do not think of your parents as your back-up plan. A back-up is called a back-up plan for a reason. If you fail to repay loans, then the back-up plan kicks in. Your parents’ support can’t be an active plan or else you are striving to fail. No way you can have credit discipline with such an approach.
Do not let your EMIs breach a certain threshold of your in-hand income. Let’s say 40% or 50%. The threshold may look quite high to you. However, I am accounting for a home loan too. If you stick to these thresholds, you will avoid some of these insipid loans.
EMERGENCY OR UNAVOIDABLE LOANS
Purchase adequate life, health and disability insurance.
Build emergency buffers.
Save a portion of your income in recurring deposit or invest in mutual funds by way of SIPs.
A chain is only as strong at its weakest link. Similarly, a financial plan is only as strong as its ability to handle a crisis. Many of us feel that we have things under control financially. Suddenly, something hits us in the face, and everything goes for a toss. It could be loss of job, expensive treatment, unplanned family support or anything else. Work towards ring-fencing your finances. Purchase adequate life (or your family will struggle after you), health and disability insurance. Build emergency buffers. As we talked about having threshold for loans, you must also consider saving some portion of your income religiously. The number could be 10%, 20%, 30% or any other number. Keep/invest this amount the day you receive your salary. This amount could be put in recurring deposit, fixed deposit or in mutual funds by way of SIPs. This will improve your ability to handle financial crisis and avoid unnecessary loans.
Do not borrow just because you can. You can argue, shouldn’t these companies/fintech lenders have some checks before they lend? Perhaps they do. Perhaps, the credit guidelines are too tax there. For you, that does not matter. If these companies lend irresponsibly, they will eventually get into problems. As a borrower, you need to exercise discretion. Do not borrow more than you can repay. And yes, give these companies some credit, they are providing easy access to credit. It is your choice to sign up.